Month: April 2012

Barbara Rehm is very optimistic about the state of US bank regulation:

What we do know is that Dodd-Frank gave federal regulators numerous and wide-ranging powers to tame too big to fail institutions. … Obviously, for any of this to work the regulators must translate these “words on paper” into tough, sensible rules, and then they must enforce them fairly and consistently.

Examiners have to be on top of what’s happening inside these systemically important firms and pounce when something goes awry.

And it’s fair to question how well the agencies are implementing Dodd-Frank so far.

Personally I’m disappointed that no one in power — say, Geithner or Fed Chairman Ben Bernanke — has made it his mission to expand the corps of examiners dedicated to the largest banks. This people should be better trained and better paid.

But when push comes to shove, the regulators will act.

This is a very romantic view of how regulation works and why we should be optimistic about regulation after the financial crisis. When Ms. Rehm writes that the regulators “overlooked gaping risk management holes because firms were booking massive profits,” she is in fact obscuring what actually happened.

The regulators often understood that the banks’ profits were derived from regulatory arbitrage with the result that insufficient capital was held against the risks held on — or as was frequently the case off — their balance sheets. They even promulgated regulations that were designed to severely curtail the growth of the asset-backed commercial paper market in 2004 precisely because the banks were not holding sufficient capital against the guarantees they were providing to commercial paper conduits.

For reasons that remain entirely unclear, at the request of the banking industry the joint bank regulators chose via guidance interpreting the regulation not to implement the regulation as it was written. It is hard to imagine that this interpretation would stand up to judicial review — if there were a path to judicial review for that guidance. (For more details on this issue, see Section II.A et seq. of this paper.)

While I would like to believe that “this time is different,” the evidence indicates that just because regulators know they have to act doesn’t mean they will be capable of effectively exercising their authority to do so.

Last week Mohamed El-Erian gave a speech at the St. Louis Fed explaining why continued extraordinary actions by the central banks risk creating more problems than they solve. He does a good job of detailing why central bank actions can only buy time for policy makers to take the actions that will solve the crisis – and the dangers of continuously buying time, when policy makers decline to recognize the nature and seriousness of the problems they face. I find some of his rhetoric dangerous however.

El-Erian repeats the mantra that “central banks succeeded in their overwhelming priority of avoiding economic depression.” But this is precisely what they have not done, because a central bank’s toolkit does not enable it to address structural problems with the balance of trade. Those must be addressed by policy makers – and thus policy makers are the only ones with the tools to avoid forced, sudden adjustments in such imbalances and economic depression. Central banks can buy policy makers the time in which to act – but they can do no more than that.

By analogy with the Great Depression, we are currently somewhere in the late ’20s. In 1925, after the Dawes plan had stabilized the European balance of payments situation via American lending to Germany, the central bankers got together and decided to work together to help Britain return to its pre-World War I peg to gold – expecting or hoping that policy makers would cooperate in this endeavor and facilitate the global rebalancing that needed to take place. Instead French policy decisions, for example, ensured a steady inflow of gold, and capital flows were overall driven by disequilibrium exchange rates until in 1931 the system broke: Britain finally acknowledged that the peg to gold could not be maintained and the international economy tumbled into Depression (though the move helped Britain put an end to a decade of stagnation).

Thus 2008 looks very like 1925. Our efforts to muddle through may have been more effective than in the late twenties, because many understand that the underlying problem of trade and capital flow imbalances must be addressed. On the other hand, policy makers’ actions have definitely been insufficient to date and there is good reason to fear that the vast challenge of international policy coordination will prove too great and that our system too will break under the stress of ongoing imbalances sometime over the next decade.

This concern was clearly expressed by El-Erian. But he chose not to call it by its name. What El-Erian is worried about is a second Great Depression. And, as he states clearly, the only people with the tools to stave off such a crisis are the policy makers. The question is whether they will fail as their 20th century forebears did before them.

Finance is substantially about controlling risk. If risk management is suitably democratized, and if its sophisticated tools are better dispersed throughout society, it could help reduce social inequality. …

The essence of finance is that contracts should benefit all parties.

This last sentence hints at a fundamental aspect of finance that Shiller left out of his New York Times essay: asymmetric information. Financiers — in the process of gaining the information necessary to “manage risk” — have access to information that is essential to pricing assets that trade for millions — and even billions — of dollars every day. You and I don’t. If we want the financiers to do their jobs in the public interest — however we choose to define that — we will have to compensate them for not abusing their privileged position. Even when banks acted mostly as utilities, the 3-6-3 banking rule was a clear indicator that bankers were well-compensated for behaving themselves.

What worries me about seeking to “democratize Wall Street” is that the goal of democratization has been pursued for decades. And most of the laws passed with this goal seem to just make Wall Street richer. There was a time (before most of us were born) when stock brokers earned incomes like bankers. The charged a relatively high fee for every trade and mostly worked for a small well-to-do clientele.

In 1969 Time Magazine asked “Should brokerage firms be allowed to sell their own stock to the public, thereby letting the ordinary investor in on Wall Street’s enormously profitable business?” And as we all know the answer was yes. The NYSE let member firms go public. Access to the vast capital of public markets allow newcomers to reduce the commissions paid on stock trade dramatically — this too democratized access to the markets.

More or less at the same time, the NYSE ended its unofficial policy of protecting the customers of member firms from losses due to a member firm bankruptcy. (cf. Ira Haupt & Co. 1963 and Dupont-Homsey & Co. 1960). The SIPC was founded in 1970, backed not only by member contributions, but also by a line of credit from the Treasury. That is, hand-in-hand with “democratization” of stock trading came government insurance against tail risk.

Stocks are now cheap to trade and within the financial reach of many Americans. But it’s far from clear that democratization of the gains from trading in the stock market have accompanied this change. From the “spinning” of IPOs to the growth of hedge funds and the movement of significant financial activity to “over-the-counter” derivatives markets, the rich and connected still have better ways of making money from the markets than the rest of us. And it’s far from clear that you can write a law that will prevent financiers with access to information the rest of us don’t have from reaping the gains of the information in one way or another.

Maybe we should give up trying to democratize finance and turn our focus to reining in its excesses — while recognizing that a good share of the profits from finance will always end up flowing to the financiers.

Paul Krugman’s critique of Steve Keen’s work has set off a debate in the econoblogosphere over the degree to which bank creation of money is constrained by central bank policy. The clearest explanation of what, I think, is also Krugman’s view is presented by Nick Rowe:

An individual commercial bank can create money out of thin air simply by buying something. But the money it creates may not be its own. Its money may subsequently be redeemed for the money of another bank, or the central bank. The individual commercial bank that wants apermanent increase in its stock of money may need to persuade people not to redeem its money. Whether or not it needs to do anything to persuade them all depends on how the other banks, especially the central bank, react.

I can imagine a world in which an individual commercial bank can permanently create money. All it needs is that the central bank, which is free to do what it wants, allows the supply of its own money to increase in proportion to the supply of commercial bank money. This is what would happen if the central bank targeted a rate of interest, for example. One commercial bank creates money, and all the other commercial banks, and the central bank, respond to the hot potato process by increasing their own money supplies in response to the rising demand for loans and deposits and currency.

I read these two paragraphs as a statement that the velocity of money (with respected to the monetary base or currency) tends to be constant. It’s far from clear to me why this would be the case — probably because the basic model of a credit-based monetary economy that I work with has infinite velocity; that is, the model demonstrates that the optimal solution to a monetary problem is an institutional structure with a monetary base of zero. (See here for a formal model and here for a heuristic discussion of the model.) The basic idea of this framework is that if a monetary problem exists, “good” credit will always be a better solution to the problem than money. The question then becomes how do you establish a “good,” i.e. very low default, credit system.

My model of banks has them financing working capital (which they have been doing for centuries). If one thinks of bank lending as the means by which the value of inalienable assets — the entrepreneur’s personal knowledge — are realized, then when banks are lending wisely and true value is being realized via bank lending while at the same time the monetary base is being held constant, the velocity of that base should increase since true new value is being created. The problem arises when banks miscalibrate and lend unwisely, then there can be a temporary increase in velocity before the mistake is recognized as such, followed by a decline back to the “true” velocity given the “true” value of output.

I think the difference between my model and the one that Krugman and Rowe are working with is that they assume that economic output is not a function of bank finance, that is, output simply comes into being frictionlessly* and banks are then tacked onto this economy. (In their posts Krugman‘s banks “offer a better tradeoff between liquidity and returns” and Rowe‘s banks “buy something”.)

By contrast, I assume that any output that exists, exists because it is financed by the banks — thus, an increase in “good” bank activity necessarily increases real GDP. If the monetary base is held constant, the velocity of money will increase. If this model is correct, then there is no need to “persuade” anyone to hold additional bank money, because the economy demands that money in order to pay for the real goods that were produced using bank financing.

* Update 4-3-12: Since a “friction” has many definitions in the economic literature, I should be specific that I am talking about monetary frictions here that create a role for a means of exchange. In my lexicon that’s the missing friction that makes general equilibrium models very hard to relate to the real world — and by assumption eliminates the obvious role of banks.